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Published: November 2, 2009
 / Winter 2009 / Issue 57

 
 

What Banking Needs to Become

The unbundled value chain might still have been sustainable if investors had been able to accurately gauge the quality of the loan packages and other assets they bought. Unfortunately, rating agencies were paid by the same institutions that issued these securitized assets and, in some cases, actually worked with them to produce the numbers needed to reach the desired rating outcomes. As this played out, and as financial-services products became more complex and difficult to analyze, the effectiveness of credit ratings was quietly compromised.

The crisis has forced bankers to recognize that as they shifted the ownership of their loans — and the customer relationships those loans represented — to others, they reduced the transparency of their practices and increased their risk. To reverse the situation as global financial markets decrease their leverage, banks will have to reevaluate and redesign their value chains. They will return to more vertically integrated management systems, bringing their underlying assets and their customer-oriented capabilities back under tighter control. They must particularly focus on getting closer to their customers.

Living in a Low-growth Environment

A rising tide lifts all boats, it is said. And few exceptions appeared in global banking between 2001 and 2007. Many banks took advantage of favorable margins and thin capital buffers to set new hurdle rates: Only those products with 20 percent return on equity or more were acceptable. To provide returns to their own shareholders, they relied on a simple formula: Increase cash earnings by 10 to 12 percent annually by growing revenues in the high single digits and keeping cost increases in the low single digits; use high dividend payouts to add another few percentage points; and exploit their own continually rising price-to-earnings (P/E) ratios to offset low margins and the cost of capital in the banking sector.

This formula will no longer work, for several reasons. First, a quick economic rebound is unlikely. The current slump has already cut deeper and lasted longer than any recession to hit the U.S. economy since the Great Depression. It continues to affect consumer buying patterns around the world. Beyond the standard boom-and-bust cycle, this crisis is underpinned by fundamental structural imbalances that will take years, even decades, to work through, such as the U.S.–China trade deficit, the mismatches in growth rates among nations that have adopted the euro (the “euro zone”), the size and likely duration of the U.S. budget deficit, and the disparity between personal saving rates in Western and Asian economies. Even under the best scenarios for economic recovery, with speculation curtailed, asset growth in the financial sector will be significantly subdued.

A second reason banks must change their approach: They will have to keep a tight lid on expenses just to maintain their margins. And cutting costs will not be easy for them. The need to comply with increasing regulatory demands and to invest in a significant refocusing of capabilities — both of which are prerequisites for operating in the post-crisis environment — will create upward cost pressures.

Third, the price-to-earnings ratios for banks, which have often influenced share prices and thus financial incentives in the past, will languish. Banks can no longer afford to pay out large amounts of cash as high dividends to attract investors. In addition, P/E ratios are likely to reflect an expectation of lower risk and return over the medium to long term.

To see how conditions like these have played out in the past, it is worth revisiting the last major recession, that of the early 1990s, and the asset clearing period that followed. Margins initially widened as banks were able to pick and choose customers and dictate loan terms. Profit growth was generated mainly by working out bad debts. But margins soon shrank and the burden for generating growth shifted back to cost reduction.

 
 
 
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Resources

  1. Shumeet Banerji, Paul Leinwand, and Cesare R. Mainardi, Cut Costs, Grow Stronger (Harvard Business Press, electronic book, 2009): Step-by-step insights for reducing expenses dramatically by focusing on a coherent system of capabilities.
  2. Alan Gemes, Peter Golder, and Thorsten Liebert, “Global Financial Governance: Improving Stability and Mitigating Future Threats,” Booz & Company white paper, September 2009: Basic principles for the next generation of financial-services regulation.
  3. Henry Kaufman, The Road to Financial Reformation: Warnings, Consequences, Reforms (Wiley, 2009): A banker’s perspective on thehistorical precedents for the current crisis, its likely aftermath, and the impact on regulation and the industry.
  4. Yoshiyuki Kishimoto, Hiroyuki Sawada, and Chieko Matsuda, “Follow the Customer, Follow the Car,” s+b Leading Ideas Online, 12/17/08: Lessons from Japan’s “lost decade” reinforce the imperative of being close to the customer and the dangers of excess capital.
  5. Andrew Turnbull, “Is State Control Making a Comeback?s+b Leading Ideas Online, 04/28/09: Why permanent government control of banks is unlikely — but a new regulatory environment is assured.
  6. For more thought leadership on this topic, see the s+b website at: www.strategy-business.com/finance.
 
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